Equities: taking the long view

The stock market is frequently, sometimes justifiably, seen as the epitome of short-termism. There are plenty of instances where the opposite is true, although accurately assessing companies’ long-term prospects is not straightforward, writes Giles Parkinson.

Concerns that short-termism can adversely impact corporate behaviour has been high on policymakers’ agenda for some time. In 2012, a UK government-backed review of equity markets and long-term corporate decision-making found instances of investment myopia among both fund managers and company boards. The report’s author, London School of Economics professor John Kay, warned the culture of short-termism was hurting Britain's economy.1

In reality the situation is more nuanced. While there may be plenty of cases of short-termism, the market frequently takes an appropriately long-term view. After all, US consumer goods giant Kraft Heinz ultimately failed in its attempt to buy Anglo Dutch rival Unilever earlier this year, partly because of the latter’s ability to convince investors its sustainable business model would reap even bigger rewards over the long term.

That is not to say companies’ long-term outlook is always accurately reflected in their share price. There are many examples where prospects are underappreciated – and for that matter overestimated too. One of the hardest challenges for investors, yet arguably the most important, is to assess whether the long-term prospects of a company are accurately valued.

Sacrificing profits today for growth tomorrow

Companies face a choice: either they try to maximise margin and cash flow in the near term but suffer lower growth as a consequence, or they take a ‘long-term’ view; accepting lower margins so as to continually reinvest in their business to achieve higher growth.

Amazon, Costco and Lindt are examples of companies that sacrifice margins and profits today for higher future growth, and where this is appreciated by the market. Amazon’s underlying profitability is obscure, but since its creation founder Jeff Bezos has exalted the long-term. “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we'll take the cash flows,” he wrote in his inaugural letter to shareholders in 1997.

The company’s margins are negligible, yet its approach has enabled Amazon to take one in every two dollars of the entire growth in US online sales last year. The shares’ price/earnings (P/E) ratio is 117. In contrast, the S&P 500 index trades on a P/E of 26.

US discount retailer Costco earns wafer-thin margins, regardless of how much bargaining power over suppliers or scale efficiencies it can extract. The company makes the vast majority of its meagre 3.1 per cent margin from shopper-subscription fees, which have only been raised ten per cent in the last decade, far below inflation. The company’s stock trades on a P/E ratio of 30, compared with rival Wal-Mart’s 16.

Swiss confectioner Lindt in 2016 reported a 14 per cent margin as it continues to patiently invest overseas, which may not bear fruit for a decade or more. The company reported organic revenue growth of six per cent. In contrast, US rival Hershey delivered a 20 per cent margin, yet organic growth was below one per cent. With Lindt shares trading on a P/E ratio of 35 compared to Hershey on 23, the latter’s loss-making international division is coming under increased scrutiny.

Not only do Amazon, Costco and Lindt consciously hold back margins by choosing to continually reinvest for better growth; it is their longstanding policy to do so.

Be wary, growth may disappoint

Of course, there is nothing to prevent a company hitherto earning a low margin from unveiling a new strategy aimed at boosting it. As it starts to make progress towards its goal, earnings rise, the P/E multiple expands as the market starts to price in faster growth, and the shares may attract a new following. However, the long-term orientated investor needs to be wary. It is important to determine whether these higher profits are likely to come at the expense of future growth.

Arguably, US-focused food producers General Mills, Kellogg’s and Campbell Soup have all gone down this cul-de-sac in recent years and are in the process of being reappraised negatively by the stock market.

For instance, in mid 2016 General Mills unveiled a target to grow its operating margin to 20 per cent by 2018. The share’s P/E multiple promptly expanded to 23, having been 19 the year before. Since then, however, cumulative sales have contracted by seven per cent on an organic basis and analysts are now openly questioning the margin goal. Both the share price and P/E multiple are now below where they were ahead of the announcement.

The market isn’t always right

While it may be true that in many instances a company’s long-term prospects will be accurately recognised, that is not always the case. This is hardly surprising in a world where rapid technological changes can wipe out a business model almost overnight. Eastman Kodak, Nokia and Blockbuster Entertainment are three high-profile examples of companies whose long-term growth prospects were pretty much destroyed at a stroke.

The implication for investors is that it pays to be cautious when evaluating the growth prospects of companies vulnerable to the impact of technological change.

There are other occasions when the market can underappreciate a company’s long-term growth prospects if they are obscured by short-term factors. Take British confectionary group Cadbury Schweppes. In the mid 1990s it attempted to open up the Chinese market to Western chocolate, beginning with a pilot study in Hong Kong, Beijing and Shanghai.

While the company made mistakes, the trials showed sufficient promise that they were expanded to 200 cities. But at this point, costs started to escalate, causing material losses. Cadbury was creating cohorts of loyal consumers with high lifetime value at the expense of accounting appearances. Yet the company’s management failed to convince investors of the ongoing value-creation in the project and the stock languished on a lowly P/E multiple.

Under increasing pressure from shareholders, the company ultimately curtailed its Chinese ambitions. While that boosted profits, it arguably destroyed shareholder wealth. The rest of the story is corporate history: the Schweppes drinks business was spun off as Dr Pepper Snapple and Cadbury was bought by Kraft.

Communication skills

The fact that companies such as Amazon, Costco and Lindt, with a prominent commitment to investing for growth, are rewarded by investors is testament to long-termism. However, management must also play a part in communicating the extent to which their company’s reported numbers diverge from true economic value.

Heineken, Unilever and Nestle all extol the virtues of planning decades ahead, but this is not reflected in their valuations. Each has margins generally below their peers and report average-to-better revenue growth, yet there is no corresponding premium in P/E multiples.

In all three cases, the companies’ management must do a better job of explaining whether margins are held back by competition or a decision to invest for growth. If the latter, they need to explain why it will result in superior growth. The response to activist investors should not necessarily be short-term goals and restructuring. By laying out a clear long-term strategy there is every chance companies will be rewarded by investors.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 10 April 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/0495/31072017

Giles Parkinson

Fund Manager, Global Equities

Main Responsibilities

Giles is responsible for the management of our Global Equity Endurance Fund. Prior to joining Aviva Investors, Giles held positions as an analyst at Artemis Investment Management and before that at Newton Investment Management.

Experience and qualification

Giles holds a BA in History from Durham University and an MPhil in Historical Studies from Cambridge University. He is also a CFA® charterholder.